Wait For ADP's Valuation to Improve

On July 27, 2022, Automatic Data Processing (ADP) released strong Q4 and FY2022 results and an encouraging FY2023 outlook. Despite an increase in ADP's adjusted diluted EPS guidance relative to FY2022 results, the sudden surge in ADP's share price has led to a slight deterioration in its valuation from the time of my last analysis. I think investor euphoria will wane and will wait for ADP's valuation to improve before I add to my exposure.

I last reviewed Automatic Data Processing (ADP) in my January 27, 2022 post. Although ADP's valuation was in the upper 20s, my experience as an ADP shareholder for roughly 2.5 decades led me to acquire 100 shares at ~$197.50 on January 26, 2022 in one of the 'Side' accounts in the FFJ Portfolio.

The vast majority of my ADP shares are held in a retirement account for which I do not disclose details. This explains why ADP was my 15th largest holding when I completed my Mid 2022 Investment Holdings Review even though I only reflect 100 shares as being held in the FFJ Portfolio.

Business Overview

I dispense with a business overview since this was included in my previous ADP post. However, I once again include links to sources of information from which to access information to get a good understanding of ADP.

Clients Funds Investment Strategy

The purpose of ADP’s Client Funds Extended Investment Strategy is to generate income from significant client fund balances. When deemed prudent, ADP will further enhance its investment returns by investing long and borrowing short to take advantage of the yield spread.

This strategy is structured to allow ADP to average its way through an interest rate cycle by laddering the maturities of investments out to 5 years (in the case of the extended portfolio) and out to 10 years (in the case of the long portfolio). This investment strategy is supported by ADP's short-term financing arrangements necessary to satisfy short-term funding requirements relating to client funds obligations.

At FYE2022 (June 30), ADP had $49,569.2B held for clients.

Compared to FY2021, ADP reported an increase of:

  • 23% to $0.127B and 7% to $0.452B of interest on funds held for clients in Q4 and FY2022.
  • 12% to $32.8B and 19% to $32.5B in average client funds balances in Q4 and FY2022.

The average interest yield on client funds increased to 1.5% in Q4 from 1.4% and decreased to 1.4% from 1.5% for the fiscal year.

When I wrote my prior review, ADP had generated $0.207B of interest on funds held for clients in the first half of FY2022. We see that ADP generated $0.245B of interest on funds held for clients in the second half of FY2022.

As we will see in the FY2023 Outlook section further in this post, ADP stands to benefit from a rising interest rate environment.

A comprehensive overview of ADP's Clients Funds Investment Strategy is found in Note 6 in ADP's Q3 Form 10-Q starting on page 10 of 46.

Financial Review

Q4 and FY2022 Results

ADP's Q4 and FY2022 results are reflected in this Form 8-K and the accompanying earnings presentation; the FY2022 Form 10-K is not yet available.

ADP's CAPEX requirements are well below those of capital-intensive industries. This is a strong advantage when it comes to generating Free Cash Flow (FCF).

ADP's FY2012 - FY2022 FCF (in Billions of $) is $1.661, $1.342, $1.518, $1.639, $1.511, $1.655, $2.044, $2.122, $2.410, $2.587, and $2.925.

FY2022 Outlook

The following is ADP's FY2023 outlook.

ADP - Fiscal 2023 Outlook - July 27, 2022

Source: Q4 and FY2022 Earnings Presentation - July 27, 2022

For client funds interest revenue, ADP expects higher overnight interest rates and higher repurchase rates on maturing securities together with balance growth to lead to higher interest income.

The short funds portfolio is invested in overnight securities. This portfolio should benefit from higher interest rates assuming the Federal Open Market Committee increases the Fed funds rate over the year.

The client extended and long portfolios will benefit as ADP reinvests maturing securities at an expected rate of ~3.3%.

When both of the above are combined, the expected average yield should increase from 1.4% in FY2022 to 2.2% in FY2023.

ADP expects client funds balances to grow 4% - 6% and client funds interest revenue to increase from $0.452B in FY2022 to $0.72B - $0.74B in FY2023.

The net impact from its client fund strategy, however, will increase by a bit less from $0.475B in FY2022 to $0.675B - $0.695B in FY2023. The slightly lower growth is due to the expected increase in short-term borrowing costs which track the Feds fund rate. These borrowings enable ADP to ladder its portfolio and invest further out on the yield curve than it otherwise not do if this strategy was not used. As ADP gradually reinvests its maturing securities, however, this gap between client funds revenue and the net impact from ADP's client fund strategy should reverse and become positive.

I include ADP's previous outlooks so you can readily compare the gradual improvement.

Risk Assessment

There is no change to ADP's senior unsecured domestic long-term debt credit ratings from the time of my last review.

  • Moody's: Aa3
  • S&P Global: AA-
  • Fitch: AA-

The outlook assigned by all 3 rating agencies is 'stable'.

All ratings are the bottom tier of the upper medium-grade investment-grade category. They define ADP as having a very strong capacity to meet its financial commitments and differ from the highest-rated obligors only to a small degree. 

These ratings satisfy my conservative investment preferences.

Dividends and Share Repurchases

Dividends and Dividend Yield

ADP's dividend history currently reflects the distribution of three $1.04 quarterly dividends. We can expect one more quarterly dividend distribution at this level at the beginning of October.

Using the current ~$239.50 share price, the dividend yield is ~1.7% versus ~2.1% when I acquired shares at ~$197.50 on January 26, 2022.

I expect ADP's next dividend increase will be less than that declared in November 2021 ($0.93/share increased to $1.04/share). A quarterly dividend increase of ~$0.05 - ~$0.07 seems more likely. If we use the $0.06 mid-point, the quarterly dividend will likely rise to $1.10/share.

With 1 more $1.04 dividend and 3 at $1.10, the next 4 quarterly dividends will likely total $4.34. This would give us a forward estimated dividend yield of ~1.8% based on the current share price.

Share Repurchases

The FY2012 - FY2022 weighted average share outstanding (in millions) is 492, 487, 483, 476, 459, 450, 443, 438, 433, 428 and 421.

  • FY2019 - ADP purchased ~6.5 million shares at an average price per share of $143.02.
  • FY2020 - ADP purchased ~6.2 million shares at an average price per share of $160.61.
  • FY2021 - ADP purchased ~8.2 million shares at an average price per share of $170.04.
  • FY2022 - ADP purchased ~8.2 million shares at an average price per share of $170.04.
  • In Q3 and the first 9 months of FY2022, ADP spent ~$0.498B and ~$1.554B to repurchase 2.3 million shares and 7 million shares, respectively. It spent ~$1.970B to repurchase outstanding shares in all of FY2022.

Valuation

ADP's diluted PE ratio in the FY2012 - FY2021 timeframe is 20.41, 28.25, 26.22, 28.33, 30.77, 29.74, 33.79, 31.40, 30.59, and 39.02.

When I wrote my July 29, 2020 post, ADP's diluted EPS forecast was $4.73 - $5.02. With shares trading at ~$137, the forward PE range was ~27.3 – ~29. In addition, ADP’s adjusted diluted EPS forecast was $4.85 - $5.15 giving us a forward adjusted PE of ~26.6 – ~28.3.

When I wrote my January 27, 2022 post, management's FY2022 adjusted diluted EPS guidance called for a 12 - 14% increase from the $6.02 reported in FY2021. Using the current ~$197.50 share price and adjusted diluted EPS guidance of ~$6.74 - ~$6.86, the forward adjusted diluted PE range was ~28.8 - ~29.3.

Using the brokers' forward-adjusted diluted EPS estimates reflected on the two online trading platforms I use, the forward-adjusted diluted PE levels were:

  • FY2022 - 19 brokers - mean of $6.81 and low/high of $6.72 - $6.91. Using the mean estimate, the forward adjusted diluted PE is ~29 and ~28.6 if I use $6.91.
  • FY2023 - 19 brokers - mean of $7.55 and low/high of $7.25 - $7.85. Using the mean estimate, the forward adjusted diluted PE is ~26.2 and ~25.2 if I use $7.85.
  • FY2024 - 10 brokers - mean of $8.43 and low/high of $8.11 - $8.60. Using the mean estimate, the forward adjusted diluted PE is ~23.4 and ~23 if I use $8.60.

Only 10 brokers provided FY2024 estimates so I disregarded this guidance.

In FY2022, ADP reported $7.00 and $7.01 of diluted EPS and adjusted diluted EPS. Using the current ~$234.80 share price, the diluted PE and adjusted diluted PE is ~33.5. This is an improvement from the level in 2021 but is not that much different from the previous few years.

The current FY2023 adjusted diluted EPS outlook calls for a 13% - 16% increase from FY2022's adjusted diluted EPS of $7.01. This gives us a forward-adjusted diluted EPS range of ~$7.92 - ~$8.13. With shares currently trading at ~$239.50, the forward adjusted diluted PE range is ~29.5 - ~30.2.

The forward-adjusted diluted PE levels using the current broker estimates reflected on the two online trading platforms I use are:

  • FY2023 - 19 brokers - mean of $7.97 and low/high of $7.40 - $8.18. Using the mean estimate, the forward adjusted diluted PE is ~30 and ~29.3 if I use $8.18.
  • FY2024 - 17 brokers - mean of $8.95 and low/high of $8.57 - $9.17. Using the mean estimate, the forward adjusted diluted PE is ~26.8 and ~26 if I use $9.17.

Only 4 brokers have currently provided their FY2025 earnings estimates so I exclude these estimates in my valuation calculations.

The ~$42 surge in ADP's share price from when I added to my exposure on January 26, 2022, is somewhat offset by the increase in the forward-adjusted diluted EPS estimates. ADP's valuation, therefore, is only marginally higher.

Final Thoughts

In my June 30, 2022 Paychex (PAYX) post, I indicate that it should benefit from a rising rate environment; I added to my PAYX exposure on June 30 based on its ~27.5 - ~27.7 forward adjusted diluted PE range.

ADP is PAYX's much larger competitor and carries substantially more client funds on deposit. ADP should, therefore, generate more interest income in a rising interest rate environment than PAYX.

I do not think it is a stretch to expect ADP's share price to pull back to the mid $220 range once the euphoria wanes following the release of ADP's strong FY2022 results and FY2023 outlook. In addition, there are signs the labour market could deteriorate if the US and Canadian economies slip into a recession. I, therefore, am cautious that top-line growth could moderate in the second half of FY2023 before we witness a recovery in 2024.

Using ADP's forward-adjusted diluted EPS outlook of ~$7.92 - ~$8.13, a $225 share price would give us a forward-adjusted diluted PE range of ~27.8 - ~28.4. I would add to my ADP exposure if its valuation were to reach this level.

I wish you much success on your journey to financial freedom!

Note: Please send any feedback, corrections, or questions to [email protected].

Disclosure: I am long ADP and PAYX.

Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your own research and due diligence. Consult your financial advisor about your specific situation.

I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.